Nov. 29 (Bloomberg) -- Bank of England Governor Mervyn King
signaled U.K. banks may need to build up the capital they hold
against potential losses, and asked regulators to report back by
March on how lenders will comply.

Banks may need to make bigger provisions for future loan
losses and the cost of regulatory fines and customer redress,
King told reporters in London today. He said that risk-weightings may also be inappropriate, as he presented a report
which said the capital ratios that they are used to calculate
may be overstated by as much as 35 billion pounds ($56 billion)
by the country’s four biggest banks.

“This problem is manageable but it requires some action
now,” King said. “Just deal with it now. There’s no reason why
the actions that need to be taken can’t be taken without any
damage” to the financial system.

King is trying to press banks to raise capital levels
without prompting them to shrink lending, threatening economic
growth. Policy makers responded to the financial crisis by
cutting interest rates to record lows and forcing banks to raise
capital. That’s allowed them to hold off on foreclosing loans at
the same rates as in previous recessions.

Regulators are also increasingly concerned that banks may
be altering risk-weightings to bolster capital ratios
artificially. By changing how they calculate risk-weightings --
the probability of default assigned to loans, mortgages and
derivatives -- lenders can boost capital ratios without cutting
loans, selling assets or tapping investors.

Capital Ratios

“Alternative scenarios suggest that capital ratios for the
largest banks in the United Kingdom could be overstated by the
equivalent in capital terms of between 5 billion pounds and 35
billion pounds,” the bank said in its semi-annual Financial
Stability Report, referring to analysis of HSBC Holdings Plc,
Royal Bank of Scotland Group Plc, Lloyds Banking Group Plc and
Barclays Plc.

Lloyds Banking Group, Britain’s biggest mortgage lender,
and Barclays led the FTSE 350 Banks Index higher. The benchmark
was up was up 1.3 percent as of 12:58 p.m. today in London
trading. HSBC and Royal Bank of Scotland were up 1.3 percent.

King expressed concern that unlike previous recessions,
banks may not be foreclosing on enough loans or recognizing
potential losses soon enough. Today is his penultimate Financial
Stability Report before he is replaced by the current Bank of
Canada Governor, Mark Carney, in July.

Health Analysis

“In judging whether banks are adequately capitalized, we
need to ensure that reported capital ratios do in fact provide
an accurate picture of banks’ health,” King said.“At present,
there are good reasons to think that they do not.”

The Financial Policy Committee’s semi-annual report
recommended that the Financial Services Authority should take
action to see that capital reflects a “proper valuation of
assets” and prudent calculation of risks. It said this advice
replaces previous statements on capital.

King said that today’s recommendations, when implemented by
the FSA, “will soon get the U.K. banks back to a position where
they can support our economic recovery.”

The central bank also said that expected loan losses “are
in some cases greater than current provisions and regulatory
capital deductions.”

The FPC has been set up to use macroprudential tools and
ensure the resilience of Britain’s financial system. It said
today that where buffers were found to be wanting, the FSA
should ensure firms either raise capital or take steps to
restructure. It said banks can do this by curbing compensation
and dividends, by increasing core Tier 1 capital or selling non-core assets.

Loan Forbearance

The central bank also warned that while forbearance on
loans can be positive, it must be based on proper calculations.

The bank’s report highlighted that “inadequate and
opaque” risk provisioning of loans may mask underlying risk and
heighten profit and capital position uncertainty. It may also
impair new lending flows by mis-allocating capital to
“unprofitable lending and deferring necessary restructuring.”

“This boils down to how forward-looking a bank is when
it’s providing for the loans it’s making,” Bank of England
financial stability Executive Director Andrew Haldane told the
press conference. “We want banks to look forward in terms of
where losses might be tomorrow, to expect loss provisions, to
look through. Our recommendation is about leaning against the
potential risk.”

Misselling Costs

On conduct issues, it “seems likely that banks could face
further sizable costs for further conduct redress and potential
future legal challenges,” the Bank of England said in its
report. It noted possible costs of as much as 10 billion pounds
related to the misselling of payment-protection insurance and
Libor.

The BOE said risks to U.K. banks have eased since its last
FSR in June, in part due to the European Central Bank’s bond-purchase pledge. Still, the threats remain “considerable,” it
added.

The ECB pledged sovereign bond purchases to reduce the
financing costs of debt-strapped nations such as Spain and Italy
and safeguard the euro. The ECB expects Spain to trigger the
bond program, dubbed Outright Monetary Transactions, by
requesting aid from Europe’s rescue fund and signing up to the
required conditions, Vice President Vitor Constancio said this
week.